Mortgages

Whether you’re about to start house-hunting, or planning your savings for the next 5-10+ years, it’s helpful to understand how mortgages work and how much you’re likely to be able to borrow, as this will determine your budget.

How mortgages work 🏠

When you take out a mortgage, you’re borrowing a set amount of money to use to buy a property, alongside your deposit. So for example, someone could buy a £200,000 house using a £180,000 mortgage and £20,000 deposit.

As you make payments on a mortgage, over time, the amount of money you owe decreases.

The balance of your loan is independent of the value of your property. It doesn’t go up if the value of your property goes up, and it doesn’t reduce if the value of your property goes down.

Mortgages are ‘secured’ borrowing 🔐

The most important thing to understand is that a mortgage is secured against a property. The mortgage company takes a legal charge against the property, that gives them the right to repossess and take ownership if the loan isn’t repaid.

This makes a mortgage the most serious borrowing most people will have in their lifetime, and it is incredibly important to keep up with repayments for this reason.

Missing payments on an unsecured personal loan may trash your credit record, but the same situation on a mortgage could result in being made homeless.

Interest and principal 📉

All mortgages involve paying interest on the money you’ve borrowed.

On a standard (‘repayment’) mortgage, in your payment each month you:

• Pay off the full amount of interest your debt has accrued that month, and
• Pay off some of the amount you owe (the principal).

For example if you borrow £150,000 at 3% interest, you would owe approximately £4,500 in interest in the first year, or £375 in interest per month, plus an amount of the capital.

How much of the principal you pay off each month depends on how long a loan you select. Payments on a 30 year loan will be much lower than on a 20 year one, as you have 10 extra years to pay off the same amount of capital. However the 20 year loan will be much cheaper overall, as you have 10 fewer years of interest payments.

Interest-only mortgages only require you to satisfy the interest payments over the term of the mortgage (in the example above, £375 per month), with the entire balance of the mortgage to pay when the term comes to an end (£150,000 in this example).

Interest-only mortgages are popular with Buy-to-Let purchases, but are hard to obtain for normal residential borrowing. To qualify for an interest-only mortgage you must demonstrate that you will have the ability to pay back the entire capital at the end of the term (known as a repayment vehicle).

Loan-To-Value ratio (LTV)

Your LTV is a comparison between the value of your property and the size of your loan. For example, if your property is worth £200,000 and you owe £100,000 on the mortgage, that’s a 50% LTV. If you’ve just purchased a property with a 10% deposit, you have a 90% LTV.

The lower your LTV, the better the interest rates that will be available to you. Specific mortgage details can vary, but rates most commonly change at 95%, 90%, 80%, 75%, and 60% LTV.

So as you pay off your loan you will be able to access lower interest rates, and this will happen faster if the value of your home increases.

Home equity and negative equity

Your equity in your home is the value of the property minus how much you owe on your mortgage.

When you sell your property, the loan you owe is paid back first, and anything remaining is yours to put towards your next property or keep as savings. That’s your ‘equity’.

Home equity is not like cash in the bank – you can’t spend it at the shops. However, you can remortgage and borrow more money against your property, for example to make major renovations.

‘Negative equity’ describes the situation where selling the property would not cover the loan. In this situation, to sell, you would have to use savings to pay the additional money owed to the lender.

Borrowing limits 💸

There are three main ceilings on how much you can borrow: your gross income, your monthly affordability, and the percentage of equity required (loan-to-value).

Income multiplier

The most you can generally borrow on a mortgage is 4.5 times your gross income. So e.g. if you earn £25,000 per year, you would expect to be able to borrow up to £112,500.

If you’re buying with someone, you can use your joint gross income.

In some cases lenders will be able to lend more than 4.5x your income, but the regulator requires this sort of lending to be less than 15% of loans granted, so it is an exception rather than the rule and usually reserved for above-average incomes.

What counts as ‘income’?

The rule of thumb is to assume that ‘income’ meant specifically guaranteed income. Lenders may additionally look at bonus, overtime, and so on, if there is good evidence of this occurring over time.

For self-employed people or company owners, lenders will typically work on two or three years of past tax returns/company accounts. Lending multiples tend to be lower as self-employed earnings are generally considered higher risk.

Affordability

As well as the maximum set by the salary multiplier, there is also a ceiling on how much you can borrow based on the affordability of the monthly payments, as calculated by the lender.

In some situations monthly affordability will be the lower ceiling, especially:

• If you’re on a lower than average income (since basic living costs take up a higher proportion of your pay)
• If you have dependants
• If you have high fixed expenses (such as an expensive car payment, or rent payment if you’re buying a shared ownership property)
• If you’re in your mid 40s or older (since you can’t stretch loans out to 30+ years, your monthly payments will be higher, and thus less affordable)

LTV/Deposit

Lenders will have a minimum amount of equity required for you to take out a mortgage. Usually this is 5% or 10% of the value of the property.

There are schemes available to help boost your deposit. Some examples are:

• LISA: This savings account boosts first-time-buyer deposit savings by 25%, up to a total £1000 for every year of saving. The main limitations are that you must be a first-time-buyer and the house purchase price must be less than £450,000.
• Shared ownership: this involves part-buying and part-renting from a local authority or housing association.
• Government 5% mortgage guarantee scheme: This is a scheme between the government and lenders, but should improve the availability of mortgages for people with 5% deposits.

Putting it all together

The maximum amount you can borrow will depend on all of the above three factors:

• You will not be able to borrow more than the lender assesses you can afford to repay on a monthly basis, even if this leads to a low loan amount offered relative to your income
• You are unlikely to be able to borrow more than 4.5x your gross income
• Even if you could afford repayments for a loan of 100% of the property value, you will still need a deposit of at least 5-10%

Mortgage options

Mortgage term

The shorter the term the less interest is paid overall, but the higher the monthly payments. One popular strategy is to go for a longer term, and thus have lower minimum payments, but overpay each month. This gives you the same ability to finish your mortgage early as you would get with a shorter term, but with the flexibility to reduce payments if you run into hardship.

Fixed and variable rate mortgages

Fixed rate

Most mortgages in the UK have a fixed interest rate for an initial set period, typically 2 to 5 years. During this period your payments stay exactly the same every month.

After that period ends, if you didn’t arrange anything else, you would move on to the lender’s Standard Variable Rate — a higher interest rate, subject to change without notice. In practice, you arrange in advance for a new fixed rate deal to start when your current one ends.

The main drawback of fixed rate is that they will include some form of ‘Early Repayment Charge’ – if you end the mortgage before the fixed term ends, you will need to pay exit fees, which are often very significant. The same penalty can apply to overpaying your mortgage by more than a certain amount even if you are not paying it off fully.

Variable rate

There are a few alternatives to fixed rate mortgages:

• Tracker mortgage – typically tracks Bank of England base rate plus a certain percentage (i.e. BoE + 2%).
• Discount mortgage – typically offers a fixed discount against the bank’s own Standard Variable Rate (i.e. SVR – 2%).

Selecting a mortgage rate

Fixed vs variable rate

Variable mortgages usually offer lower interest rates than fixed rates, but fixed rates are generally more popular. By taking a fixed rate, you tend to pay a slight premium to guarantee that your budget will remain the same for the fixed period.

2 year vs 5 year fixes

The mortgage rates available to you will reflect your current LTV. Rates improve once you cross certain LTV thresholds, most significantly at 90, 80, 75, and 60 LTV.

If you’re in a position where two years of payments will put you in a better LTV range, fixing for a longer period of time locks you in to the more expensive rates for longer.

Moving house

If you think there’s a good chance you may want to move house in a few years, bear in mind that fixed rate products typically have an Early Repayment Charge, which will apply if you pay off your mortgage by selling your home during the fixed rate period.

An alternative is to pick a ‘portable’ mortgage, which allows you to ‘port’ your existing mortgage to a new property.

What about future interest rates?

You may be tempted to ask if you should factor in the possibility of interest rates rising or falling in future, but this is generally a red herring as it’s impossible to predict.

Interest rate

Of course, all other things being equal, the lower the interest rate, the better. A better approach when comparing deals is to look at the total cost (including fees) over the fixed or discounted period only, rather than headline figures that assume years on the Standard Variable Rate.

Fees

Mortgages usually cost a fee to arrange. This can be paid upfront, or added on to the mortgage balance (in which case you will pay interest on it for the length of the loan).

Some mortgage deals have no fee. They typically have higher interest rates to compensate for this. It’s worth taking the time to calculate which combination of fees + interest rate works out cheapest, as this will vary depending on your situation.

Mortgage calculators and spreadsheets

MoneyHelper have a simple calculator for quick back-of-the-envelope calculations, and there are online amortization calculators that show how principal and interest are paid throughout the loan.

Comparing mortgage deals

There are online tools which will do a quick comparison for you, such as MoneySavingExpert’s mortgage comparison tool. Note that these calculators generally focus on which deal costs you the least in total over the fixed period, but it’s often preferable to calculate which deal costs you least in fees and interest over the fixed period.

Mortgage brokers / advisors

Mortgage brokers can be free to use, or they might charge a small fee. Whether or not you pay your broker a fee, the majority of their payment will be from the lender they arrange a mortgage with. These are known as proposal fees and should be disclosed to you by the broker.

Look for a ‘whole of market’ broker. It is generally sensible not to use the broker recommended by an estate agent, because these tend not to be so impartial.

The mortgage application and home buying process

MoneySavingExpert have a fantastic mortgage guide for first-time buyers that includes other costs and considerations such as legal fees, moving fees, and so on.